IME International Monetary

Economics
2018

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What is this course about
International Economics deals with the economic and financial interdependence
among nations – its analyses the flows
• of goods and services,
• payments and currencies
between a nation and the rest of the world, policies directed at regulating these
flows and their effect of the nations welfare.
International trade: focuses on the microeconomics of international economics
In this course we focus on the MACRO ECONOMIC aspects of international
economics
• The focus is on international financial flows and the prices that drive them –
exchange rates and interest rates
• The relationship between the real economy and the international financial flows
• Issues such as global current account imbalances the implications of the UK
leaving the EU, the rise of blockchain technology

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Recommended Text (available online)
• International Macroeconomics
• 2015c ISBN 9780170355674 Edition 1 98 Pages
• AU / NZ
• Published: 2014 by Cengage Learning Australia
• https://cengage.com.au/product/title/pp0966---
• international-macroeconomics/isbn/9780170355674

Other useful texts

• Salvatore d “ International Economics” Wiley and sons
• Krugman P. Obstfeld (2009) international Economic.
Theory & Policy. Pearson
• Additional materials will be posted on canvas

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Topics covered sequentially over
12 weeks
• 1. Balance of payments and national income accounting
2. Intertemporal Model of the Current Account
3. Exchange Rate Determination in the Short-Run and Long-Run
4. Elasticities and Absorption Approaches to the Current Account
5. The Real Exchange Rate and Non-Tradable Goods
6. Macroeconomic Policy in an Open Economy
7. Choice Of Exchange Rate Regime
8. Topics in International Macroeconomics – Optimum Currency Areas and
Crises
• 8b.Topics in International Macroeconomics The blockchain and implications
for the Macroeconomy

Tutorial Questions are available on canvas under each topic

Do the exercises prior to attending class

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Assessment
1) Assessment A : 10%
• Online Quiz’s- to be completed via Canvas weeks 4, 5, 7, 11, 12= 10%
(check dates on canvas as different schedules for LF01 & LF02)
• 2% each
• The tests will consist of multiple choice and T/F questions.

2) Assessment B : 20%
• Executive summary report – with collaboration documents

3) Assessment C: 20%
• Multimedia presentation – 3 minutes

Final examination: 50%

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Topic 1:
Balance of payments and
national income accounting
Contents
Balance of Payments Accounting
Foreign Debt
National Income Accounting and the Open
Economy

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Learning objectives – Topic 1
• Understand what the balance of payment is and what it
measures
• Understand the meaning of credits and debits, and
double entry bookkeeping
• Explain why the current account balance is
economically important
• Relate the current account balance to changes in a
country’s net foreign wealth
• Utilise national income accounting identities to explore
the relationship between savings, investment and the
current account.

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BALANCE OF PAYMENTS
ACCOUNTING
• National income is often defined to be the income earned by a
nation’s factors of production.
 Gross national product (GNP) is the value of all final goods and services
produced by a nation’s factors of production in a given time period.
 Gross domestic product (GDP) measures the final value of all goods and
services that are produced within a country in a given time period.
GNP = GDP
+ payments from foreign countries for factors of production
– payments to foreign countries for factors of production
• Definition: The Balance of Payments is an aggregate statement of a
country’s international transactions in a given period of time.
• One of the entries in the balance of payments reflects the purchase (or
sale) of a good, service or financial asset. The other entry reports what has
been given in exchange, the payment for the good, service, or asset.

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Simple rules:
• A country’s balance of payments (BOP) accounts
measures all international economic transactions
between the residents of a country and foreign residents.
• The BOP is constructed on the basis of double entry
book keeping
• Each transaction is recorded twice:
once as a credit and once as a debit.
– If you have to pay a foreign resident,
normally in exchange for something that you bring
into the country, then that something counts as a
debit.
– If a foreign resident has to pay you
for something, then the something counts as a credit.

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Simple example
Credit Debit
Import a car from Japan
Debit on BOP Import Car -
Export JPY in
Export currency in exchange
exchange for
Credit on BOP
car

But which sub accounts?

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Balance of payments accounting
• Composed of two primary sub accounts, the Current
Account and the (Capital) Financial Account:
– Current account: CA records flows of goods, services,
income on assets
– (Capital)Financial account: FA records flows of assets
– In addition, the Official Reserves account (ΔIR) tracks
government currency transactions
– A fourth account, the Net Errors and Omissions account is
produced to preserve the balance of the BOP.

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Current Account (CA)
• Measures a country's net exports of goods and services and net
international income receipts (iNFA = income earned on foreign assets
owned by domestic citizens minus income paid on domestic assets owned
by foreigners -including interest payments, dividends and profits).
CA = (X – M + iNFA)
- Exports are recorded as a credit (+) on the current account.
- Imports are recorded as a debit (-) on the current account.
• An entitlement to the receipt of income from abroad is recorded as a
credit. The obligation to make a payment of income to a foreign resident
is recorded as a debit.
• A current account surplus is where credits exceed debits, that is when
exports and income received from abroad are greater than imports and
income paid to foreign residents.
• A current account deficit is where debits exceed credits.
Singapores Current account?

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Singapores - Current account
balance - Singstat

• Visualising the balance of payments – 1985 – 2016

• The Current account balance

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Singapores Balance of payments
Items Latest Latest % Previous
Period Data Change Period Data
(Y-o-Y) 1/
Balance of Payments S$m Q1/17 16,613.8 290.5 -3,926.7

Current Account Balance S$m Q1/17 19,398.0 21.9 18,129.9

Exports of Goods and Services S$m Q1/17 184,787.1 11.2 186,331.1

Imports of Goods and Services S$m Q1/17 160,083.2 12.2 160,645.7

Primary Income Balance S$m Q1/17 -1,679.2 na -3,741.3

Secondary Income Balance S$m Q1/17 -3,626.7 na -3,814.2

Capital and Financial Account Balance S$m Q1/17 3,283.0 na 22,727.0

Reserve Assets (decrease in assets and S$m Q1/17 16,613.8 na -3,926.7

liabilities, and net inflows in net balances, are
indicated by a minus [-] sign)
Official Foreign Reserves US$m Jun-17 266,303.0 7.0 264,556.4

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Financial Account (FA)

• Net change in foreign ownership of investment assets

• Measures the difference between sales of assets to
foreigners and purchases of foreign owned assets.
• Sales of assets to foreigners be it direct, portfolio,
investment in financial derivatives or other investment
(including currency and deposits) is recorded as a credit
entry on the financial account.
• Purchases of assets located abroad are recorded as a
debit entry on the financial account. (import the asset)
• FA = – ΔNFA = Change in Net Foreign Assets

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Current Account vs Financial Account

• Singapores Financial account

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Fundamentals of BOP Accounting
Credit Debit
Current account (CA)
Merchandise Exports Imports
Services Exports Imports
Primary income (iNFA) Received Paid
Secondary income (remittances, transfers) Received Paid
Financial Account (= – ΔNFA)
Foreign assets owned by domestic (FA) Decrease Increase (Buy)
Domestic assets owned by foreigners (FL) Increase Decrease

Change in Official Reserves Decrease in R Increase in R

(= – ΔIR)

Errors & Omissions (Statistical Discrepancy)

= Sum of credits minus sum of debits
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Example 1
• Suppose a Singapore resident wants to purchase something in Japan and
thus needs Japanese currency to make the purchase.

• The Singaporean currency sold is recorded as a credit entry in the

financial account. Ownership changes from a Singaporean resident to a
foreign resident.
• The Japanese yen purchased is recorded as a debit entry on the
financial account, valued at the current exchange value.

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Example 2
Assume that the Singaporean resident uses his yen to purchase a camera
from a store in Japan and then brings it back to Singapore.

The item sold in this case is Japanese currency, reflecting a decrease in

holdings of foreign exchange. This is recorded as a credit entry on the financial
account.
The good imported into Singapore is recorded as a debit entry on the current
account.

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Example 3
• Assume that the Singaporean resident uses his yen to purchase a
Japanese government bond.

The transaction is recorded on the financial account as a debit entry

representing the increase in domestic holdings of foreign bonds, and as a
credit entry reflecting a decrease in holdings of foreign exchange.

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Example 4
Assume a Japanese resident who owns bonds issued by a Singaporean
company receives interest payments.

The transaction is recorded on the current account as a debit entry

representing the payment of income to a foreign resident,
and as a credit entry on the financial account reflecting an increase in
Japanese financial claims against a Singaporean bank.

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Official Reserve Transactions

• Official international reserves are foreign assets held by the central bank.

• Consider the examples above. Private foreigners in Japan might not wish to
retain all of these newly obtained $SGD balances.
• If Japan is receiving more $SGD than it requires for the purchase of
Singaporean assets and imports from Singapore, then there is an excess
supply of Singaporean dollars.
• The price of the $SGD in terms of Yen will decline, and the exchange value
of the Yen will increase.
• However, the Bank of Japan may hold the view that the foreign exchange
value of the Yen is inappropriately high in which case they might purchase
$SGD in exchange for their domestic currency in order to moderate the
increase in the exchange value of the Yen.

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Official Reserve Transactions (– ΔIR)

• If the Central Bank is adding to its stock of Official Reserves it is

recorded in the Balance of Payments statistics as a debit. (Similar to
the treatment of a private citizen purchasing foreign assets, which is also
recorded as a negative in the Financial Account of the Balance of
Payments)

• A reduction in the Central Bank’s Stock of Foreign Exchange assets is

recorded as a credit in the Balance of Payments.

• Note: Under a pure floating or a flexible exchange rate the Central Bank
does not buy or sell foreign exchange

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Capital Account ( KA)
• A minor account of the Balance of Payments for many
countries.

Covers:

– Migrant transfers (goods and financial assets

accompanying migrants as they enter or leave the
country).
–
– Debt forgiveness

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Summary on BOP – the BOP must always
balance
(X – M + iNFA) – ΔNFA – ΔIR =0

Current Account Financial Account Change in Reserves

Change in Net
Foreign Assets

With no Central Bank intervention:

BOP = Current Account + Financial Account = 0
Current Account = – Financial Account = ∆NFA

If there is Central Bank intervention:

If ΔIR < 0 (the Central Bank is increasing its stock of foreign reserves),
then CA + FA > 0.

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Summary
BOP = CA + FA + KA + ΔIR = 0
•Typically the KA is relatively small and can be neglected.
BOP = CA + FA + ΔIR = 0
•The balance of payments must always balance.
•With no Central Bank intervention:
BOP = CA +FA = 0
CA = -FA
•If there is Central Bank intervention:
If ΔIR < 0 (the Central Bank is increasing its stock of foreign exchange
reserves), then CA + FA > 0.

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Review Question 1
• Question 1
Why does it make no sense to say that the
Balance of Payments is out of balance?

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Question 1
Why does it make no sense to say that the
Balance of Payments is out of balance?

• As the Balance of Payments table is

constructed on the basis of double entry
accounting every transaction will be
recorded twice, once as a debit and once
as a credit
• the sum of all debits must equal the sum
of all credits and therefore the overall
balance of payments must balance.

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 The BOP must balance. It cannot be in
disequilibrium unless something has not been
counted or has been counted improperly.

(X – M + iNFA) – ΔNFA – ΔIR =0

Current Account Financial Account Change in Reserves

Change in Net
Foreign Assets

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 Q2: Consider the purchase of a German car by a US
resident. From the perspective of Germany’s balance of
payments, how will this transaction be recorded

Credit Debit
Current account (CA)
Merchandise Exports Imports
Services Exports Imports
Factor income Received Paid
Transfer Received Paid

Financial Account (= – ΔNFA)

Foreign assets owned by domestic (FA) Decrease Increase
Domestic assets owned by foreigners (FL) Increase Decrease

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Question 2
Consider the purchase of a German car by a US resident. From the
perspective of Germany’s balance of payments, how will this
transaction be recorded?
• The purchase will be recorded as an export of goods on the
German current account. This is recorded as a credit entry (+) on
the current account.
• If the US importing firm pays US dollars to the German exporter’s
bank account in the US, this is recorded in the financial account as
an increase in foreign assets held abroad (FA), and therefore is
recorded as a debit entry (-) on the financial account.
• If the US importing firm buys Euros for US dollars from a German
bank to pay for the imports, this increases foreign assets held in
Germany, and therefore the financial transaction is recorded in the
same way. (FA owned by domestic increase - USD)
•

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 Question 3
Explain why for every Current Account transaction there is a
Financial Account transaction but there need not be for every
Financial Account transaction a corresponding Current Account
transaction.

Credit Debit
Current account (CA)
Merchandise Exports Imports
Services Exports Imports
Factor income Received Paid
Transfer Received Paid

Financial Account (= – ΔNFA)

Foreign assets owned by domestic (FA) Decrease Increase
Domestic assets owned by foreigners (FL) Increase Decrease

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Question 3
Explain why for every Current Account transaction there
is a Financial Account transaction but there need not be
for every Financial Account transaction a corresponding
Current Account transaction.

• Every time that a country sells exports or buys imports or makes an

income payment overseas or receives an income payment from
overseas there must be a financial transaction associated with it.
• if a country is selling exports overseas it must be financially
compensated for it in some way - Financial Account.
• if a country undertakes a financial transaction (eg borrowing from
overseas) there is no necessity that the other side of the transaction
will be a Current Account transaction (ie the borrowing need not be
for the financing of imports or for the financing of income payment
overseas). It could be for the purchase of a financial asset, which
will also show up in the Financial Account.

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The Economic importance of the
Current account

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Financing a Current Account Deficit

• The concept of current account balance is economically important in that it

reflects changes in a country’s net foreign assets, international investment
position, or a country’s net foreign wealth (W).
• That is, the difference between foreign assets owned by Singaporean
residents and Singaporean assets owned by foreigners (foreign liabilities).
NFA = Net Foreign Assets = Net Foreign Wealth = Net
International Investment Position
= FA (Foreign Asset ) – FL (Foreign Liabilities)
Change in net foreign wealth (W) = current account balance = - financial account
balance.
If the current account is in deficit the shortfall must be financed
A current account deficit corresponds to an exactly equal accumulation of
net financial liabilities to the rest of the world.

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There are three ways in which the
shortfall can be financed
• 1. The domestic economy can borrow from the rest of the world by issuing
financial claims (liabilities) on itself which are financial assets for the rest of
the world. This is recorded as a credit entry in the financial account. This
results in a reduction in net foreign assets (increase in net foreign liabilities).

• 2. Rather than add to debt, the domestic economy can sell off its financial
assets, both domestic and foreign, to the rest of the world. This would
appear as a capital inflow and therefore as a credit entry in the financial
account. This results in a reduction in net foreign assets (increase in net
foreign liabilities).

3 3. The Central Bank can also finance the shortfall by running down its
stocks of foreign exchange reserves which also results in a reduction in net
foreign assets (increase in net foreign liabilities).

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 Financing a Current Account Deficit
Credit Debit
Current account (CA)
Merchandise Exports Imports
Services Exports Imports
Factor income Received Paid
Transfer Received Paid
Financial Account (= – ΔNFA)
Foreign assets owned by domestic (FA) Decrease Increase
Domestic assets owned by foreigners Increase Decrease
(FL)

Decrease in R Increase in R
Change in Official Reserves
(= – ΔIR)

Increase in Net Foreign Liabilities = Accumulate foreign debt

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Foreign Debt
Net foreign debt = Singaporean non-equity assets owned
by foreigners - foreign non-equity owned by Singaporean
residents.
Overseas borrowing, by itself, does not add to net foreign
debt.
There will be an increase in foreign holdings of domestic
bonds, recorded as a credit entry on the financial account,
But,
an offsetting increase in the domestic holding of foreign
currency, recorded as a debit entry on the financial
account. There is therefore no net change in a country’s
financial account and no net change in that country’s net
foreign liabilities.
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Foreign Debt
• Foreign loans are “counter balanced”, there are three
possibilities:
• 1. purchases of foreign goods and services by domestic
residents (including income payments)
• 2. purchases of claims on foreigners (purchasing foreign
currency assets)
• 3. financing the acquisition of foreign reserves
• Net foreign debt can only increase if borrowing is
financing a current account deficit. Otherwise, borrowing
from overseas will be increasing foreign claims on
domestic assets but at the same time they will be
increasing foreign currency assets.

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Changes in net foreign wealth reconsidered
Change in net foreign wealth (W) = Current account balance + Capital gains
on W
Valuation changes arising from asset price and exchange rate movements can
cause net foreign wealth to diverge from the level implied by current account
deficits.
Example: In the US, the period 2002-2007 exhibited the largest current account
deficits since 1976. Nevertheless, US net foreign wealth improved. This
discrepancy is due to increases in the market value of U.S.-owned foreign
assets (most denominated in foreign currency ) relative to foreign-owned U.S.
assets (mostly denominated in US dollars).
•Reduction in the exchange value of the US dollar, increasing the US dollar
value of foreign currency denominated US-owned assets, leave unchanged the
US dollar value of US dollar denominated foreign owned assets.
•Stock market in foreign countries outperformed the US stock market

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 Question 4
“Irrespective of how a Current Account surplus
is used it must result in an increase in the
country’s net foreign assets” Explain
Credit Debit
Current account (CA)
Merchandise Exports Imports
Services Exports Imports
Primary income / (factor income) Received Paid
Secondary income / Transfer Received Paid
Financial Account (= – ΔNFA)
Foreign assets owned by domestic (FA) Decrease Increase
Domestic assets owned by foreigners Increase Decrease
(FL)
Decrease in R Increase in R
Change in Official Reserves
(= – ΔIR)
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Question 4
“Irrespective of how a Current Account
surplus is used it must result in an increase
in the country’s net foreign assets” Explain
• A country can dispose of its Current Account surplus in 3 ways
• 1. Reducing foreign liabilities ie repaying foreign debt, which
increases its net foreign assets.
• 2. Buying either domestic financial assets back from foreigners or
foreign financial assets from foreigners which increases net foreign
assets.
• 3. The Central Bank increasing its stock of foreign exchange assets,
which also increases net foreign assets.
• Financial Account (= – ΔNFA) – credit
1. Domestic assets owned by foreigners (FL) - decrease
2. Foreign assets owned by domestic (FA) - increase
3 Change in Official Reserves – increase in R
• (= – ΔIR)

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Question 5
Whether a current account surplus must be
offset by a financial account deficit depends
on whether the nation has a fixed or flexible
exchange rate regime. Explain.

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Question 5
• Under a flexible exchange rate regime (no Central Bank intervention):
• BOP = CA +FA = 0
• CA = -FA
• Therefore a current account surplus must be offset by a financial account
deficit under a flexible exchange rate regime.
• Under a fixed exchange rate regime:
• BOP = CA + FA + ∆IR = 0.
• CA + FA can be > 0 if the central bank increases its stock of foreign
exchange reserves (ie ∆IR< 0)
• Therefore a current account surplus need not be offset by a financial
account deficit under a fixed exchange rate regime.

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY
• Open – Economy Macroeconomics Identities
• In an open economy, domestic residents can trade both goods and services
as well as financial assets with the rest of the world.
• Total spending on domestic goods is given by:
• GDP = (C + I + G) + (X – IM)
• We need to draw a distinction between gross domestic product (GDP) and
gross national product (GNP). Gross domestic product (GDP) measures
the final value of all goods and services that are produced within a country
in a given time period. Gross national product (GNP) is the value of all
final goods and services produced by a nation’s factors of production in a
given time period.
• GNP = GDP + NI
• where NI is net international income

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY
• The relationships among the various components of GDP are described in
the national income accounts.
• Closed –Economy Macroeconomics Identities
• GDP = C + I + G
• Define gross domestic savings as
• S = GDP – C – G (where S is the sum of private sector savings and
government sector savings).

• The basic national income accounting identity implies the familiar closed-
economy identity:
• S=I

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY
• Open – Economy Macroeconomics Identities
• Using the basic national income accounting
identity and adding net investment income to
both sides we have:
• GNP = (C + I + G) + (NX + NI)
• Therefore:
• GNP = (C + I + G) + CA

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY

• Open – Economy Macroeconomics Identities

• In an open economy, our definition of saving must also
be modified to:
• S = GNP – C – G
• We can therefore derive the following identity:
• S = I + CA
• alternatively
• I = S - CA
• alternatively
• S - I = CA (note that if NI = 0, S – I = NX)

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY

• Open – Economy Macroeconomics Identities

• Insights:
• While a closed economy can only allocate savings to
the purchase of real (nonfinancial) capital, an open
economy can also allocate savings to the acquisition of
financial claims on the rest of the world.
• While a closed economy must finance investment by
saving, an open economy can do so either by saving or
reducing its net foreign wealth (borrowing abroad).
• The current account balance is the difference between
savings and investment.

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NATIONAL INCOME ACCOUNTING
AND THE OPEN ECONOMY
• If S >I
• Current Account Surplus
• Net Foreign Wealth Increasing
• Financial Account Deficit
• Lending savings to the Rest of the World

• If S <I
• Current Account Deficit
• Net Foreign Wealth Decreasing
• Financial Account Surplus
• Borrowing savings from the Rest of the World

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Is a Trade deficit bad
• A trade deficit is not necessarily a bad thing (e.g. when growing
domestic industries attract foreign investments)
– if borrowing is financing investment (which generates economic
growth and income in future) then it is not a problem
• However, if a country persistently runs a trade deficit this is
something to worry about (e.g. vulnerability to loss of foreign
investors’ confidence)
– excessive borrowing on capital account to finance consumption
on current account will incur higher interest payments and
eventually lead to reduction consumption
– For the US sustained CA deficit are attributed to GFR via global
imbalance

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Question 6
Critically evaluate the following statement
“All foreign borrowing will increase a nation’s
net foreign debt”.

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Question 6
Critically evaluate the following statement
“All foreign borrowing will increase a nation’s net foreign
debt”.

• Overseas borrowing, by itself, does not add to net foreign debt.

• There will be an increase in foreign holdings of domestic bonds,
recorded as a credit entry on the financial account, but an offsetting
increase in the domestic holding of foreign currency, recorded as a
debit entry on the financial account.
• There is therefore no net change in a country’s financial account
and no net change in that country’s net foreign liabilities.
• Net foreign debt can only increase if borrowing is financing a current
account deficit. Otherwise, borrowing from overseas will be
increasing foreign claims on domestic assets but at the same time
they will be increasing foreign currency assets.

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Question 7
“In an open economy, national savings can be
expressed as the sum of domestic investment and the
current account. This relationship can be expressed in
three different ways”. Explain.

• While a closed economy can only allocate savings to the purchase of real
(nonfinancial) capital, an open economy can also allocate savings to the
acquisition of financial claims on the rest of the world. S=I+CA
• While a closed economy must finance investment by saving, an open
economy can do so either by saving or reducing its net foreign wealth
(borrowing abroad). I= S-CA
• The current account balance is the difference between savings and
investment. S-I = CA

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Topic 1- Learning outcomes -review
• Understand what the balance of payments is and what it measures
The BOP measures all international economic transactions between
residents and non residents
• Understand the meaning of credits and debits and double entry bookkeeping
Pay a foreign resident – Imports – a debit
Foreign resident has to pay you – Exports – a credit
CA – measures flows of G+S and income on assets (NX+NI)
FA – measures flows of assets
Official reserves a/c – central bank - government currency transactions

(X – M + iNFA) – ΔNFA – ΔIR =0

Current Account Financial Account Change in Reserves

Change in Net
Foreign Assets
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Recap – Topic 1
• Explain why the current account balance is economically important
Because it reflect changes in a country’s net foreign assets, net foreign
wealth or its international investment position.
Is the country a net lender or a net saver?
• Relate the current account balance to changes in a country's net foreign
wealth
Changes in Net foreign Wealth = CA balance
If the current a/c is in deficit it must be financed. The deficit corresponds
to an accumulation of net financial liabilities to the rest of the world
• Utilise national income accounting identifies to explore the relationship
between savings, investment and the current account
• S= I+CA
• I=S-CA
• CA = S-I

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 Recall: National Income Account
If Sn > I  CA > 0  ∆NFA > 0
• Balance of Trade Surplus EX>IM
• Current Account Surplus
• Net Foreign Asset (Net Foreign Wealth) Increasing
• Financial Account Deficit
• Capital Outflow
• Lending Surplus savings to the Rest of the World

If Sn < I CA < 0  ∆NFA < 0

• Balance of Trade Deficit EX<IM
• Current Account Deficit
• Net Foreign Debt Increasing
• Financial Account Surplus
• Capital Inflow
• Borrowing savings from the Rest of the World
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Recent trends

• OECD countries : Current account balances

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Question 6
Critically evaluate the following statement
“All foreign borrowing will increase a nation’s net foreign
debt”.

• Overseas borrowing, by itself, does not add to net foreign debt.

• There will be an increase in foreign holdings of domestic bonds,
recorded as a credit entry on the financial account, but an offsetting
increase in the domestic holding of foreign currency, recorded as a
debit entry on the financial account.
• There is therefore no net change in a country’s financial account
and no net change in that country’s net foreign liabilities.
• Net foreign debt can only increase if borrowing is financing a current
account deficit. Otherwise, borrowing from overseas will be
increasing foreign claims on domestic assets but at the same time
they will be increasing foreign currency assets.

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Question 7
“In an open economy, national savings can be expressed
as the sum of domestic investment and the current
account. This relationship can be expressed in three
different ways”. Explain.
• While a closed economy can only allocate savings to the
purchase of real (nonfinancial) capital, an open economy
can also allocate savings to the acquisition of financial
claims on the rest of the world. S=I+CA
• While a closed economy must finance investment by
saving, an open economy can do so either by saving or
reducing its net foreign wealth (borrowing abroad). I= S-
CA
• The current account balance is the difference between
savings and investment. S-I = CA

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